On Monday, U.S. District Judge Laura Swain ruled on Wachovia's motion for judgment on the pleadings in CDO Plus Master Fund Ltd. v. Wachovia Bank, N.A., 07-CV-11078. Judge Swain dismissed 7 of the 8 claims brought against Wachovia by CDO Plus Master Fund, but refused to dismiss CDO Plus's claim that Wachovia breached the implied covenant of good faith and fair dealing. (Of course, she didn't rule on the merits of CDO Plus's claim either.) CDO Plus has now changed its name to VCG Special Opportunities Master Fund, but since Judge Swain still refers to them by their former name, so will I.
I think this was a bad opinion, and that Judge Swain's decision not to dismiss CDO Plus's "good faith and fair dealing" claim was based on a flawed understanding of the transaction documents. But first, some quick background: CDO Plus sold $10mm of credit default swap protection on a CDO to Wachovia. The swap was executed under a standard ISDA Master Agreement, and included an ISDA Credit Support Annex (CSA) that provided for the posting of collateral. CDO Plus was required to post $750,000 in collateral upfront, known as the "Independent Amount." The swap also required the parties to post collateral based on the mark-to-market value of the swap, or as Judge Swain explained it:

The [contract] allowed either party to demand “Credit Support” collateral whenever the party’s “Exposure,” defined as the cost to that party to replace the Trade in the market, exceeded by more than $250,000 the value of the collateral held by the party. (Credit Support Annex ¶¶ 3, 12.)

For all practical purposes, Wachovia, in its role as "Valuation Agent," was in charge of calculating each party's Exposure.¹ The long and short of it is that as the CDO market imploded, Wachovia demanded more and more collateral from CDO Plus, until eventually CDO Plus refused to post any additional collateral, and commenced litigation. Significantly, the total amount of collateral demanded by Wachovia was $10,410,000.
CDO Plus claimed that Wachovia breached the implied covenant of good faith and fair dealing because it acted “arbitrarily and irrationally” in its capacity as Valuation Agent. Judge Swain, in refusing to dismiss CDO Plus's claim, reasoned:

[CDO Plus's] allegation that Wachovia acted “arbitrarily and irrationally” is not merely a “naked assertion devoid of further factual enhancement.” ... Rather, it is amplified by the allegation that the Final Demand would have required [CDO Plus] to post collateral in excess of the notional amount.

It's true that Wachovia's final demand would have required CDO Plus to post collateral in excess of the notional amount of the swap, but the transaction documents specifically allow this. Paragraph 3 of the ISDA Credit Support Annex permitted Wachovia to make a demand for collateral equal to: "(i) [Wachovia's] Exposure for that Valuation Date plus (ii) the aggregate of all Independent Amounts applicable to [CDO Plus], if any, minus ... [CDO Plus's] Threshold."² (emphasis added)
CDO Plus was required to post a $750,000 Independent Amount upfront, but also had a $250,000 Threshold, so Wachovia was entitled to demand collateral equal to its Exposure + $500,000. That means if Wachovia's Exposure went above $9,500,000, then CDO Plus would, in fact, have to post collateral in excess of the notional amount of the swap ($10mm). Moreover, because the swap in this case was written on a mezzanine CDO tranche, which can easily lose 100% of its value, it's likely that Wachovia's Exposure went all the way to $10mm. In that case, CDO Plus would be required to post $10.5mm in collateral on a $10mm swap.
Judge Swain concluded that Wachovia's demand for $10.41mm in collateral on a $10mm swap provided "further factual enhancement" to CDO Plus's claim that Wachovia had acted "arbitrarily and irrationally" in its capacity as Valuation Agent. But it's hard to see how demanding less collateral than it was entitled to under the transaction documents could be construed as evidence that Wachovia had acted "arbitrarily and irrationally." It was perfectly rational for Wachovia to demand $10.41mm in collateral, since it had the right to demand as much as $10.5mm in collateral. Absent some other evidence that Wachovia acted "arbitrarily and irrationally," the mere fact that Wachovia exercised a right clearly given to it in the transaction documents shouldn't be remotely sufficient to survive a motion to dismiss a breach of contract claim.
There, if you're a lowly associate at a big firm who's been tasked with writing a Client Alert on this case (which a partner will inevitably take credit for), then I've done most of your work for you! I don't know why. Maybe I miss writing Client Alerts.
¹ If you thought, "Hey, why would CDO Plus allow Wachovia to calculate the amount of collateral it had to post?" then congratulations! You're smarter than AIG Financial Products, as well as 95% of CDO managers. Dealers usually insisted on being the Valuation Agent, and for reasons I never, ever understood, counterparties were usually fine with that.
² Technically, any Independent Amount applicable to Wachovia would also be subtracted, but since Wachovia didn't have to post an Independent Amount, this is irrelevant for our purposes.

17
comments:

Anonymous
said...

I generally agree that judges should stop at what the contract says, but this is one of the exceptions.

Whoever advised Wachovia to call for more than the maximum possible loss even if the document allowed for it doesn't understand lender liability or how collateral works.

Collateral secures against loss. Once there is a default, you foreclose, and if there is excess collateral, it is not yours, it needs to go back to the counterparty. Calling for more than you can possibly use, potentially blowing out the counterparty in a liquidity crunch is asking for a lender liability like claim even if the contract permitted it. That is exactly what happened.

Also, this is not really a legal argument, but I guarantee you when they negotiated the CSA, they didn't bother to focus on valuations where IM + VM exceeded the maximum liability.

Ok second comment is just silly. The safe harbors allow for termination outside the stay as well as netting. There is nothing in them at all that would allow Wachovia to have kept the excess. Folks, before you make comments on basic commercial law points, have at least a clue.

Also, to attribute what Wachovia did to Wachovia's active planning is a undue compliment. It's not like they were Goldman or something.

Anonymous @10:03: Well, the notional amount of a CDO CDS isn't necessarily equivalent to the protection seller's potential liability. Notional on a CDO CDS can vary over the life of the swap, due to things like tranche amortization, implied writedowns, etc.

But those fascinating subjects aside, I think there's a difference between "asking for a lender liability like claim" and having a court actually assume that acting within your contractual rights, by itself, is sufficient to survive a motion to dismiss a good faith/fair dealing claim. I agree with you that demanding collateral in excess of the notional amount was asking for litigation, and that Wachovia can't really complain about getting sued. But now that they've been sued, and they've incurred the litigation costs, I think they deserve to have the court make the correct decision. I don't think acting within your contractual rights, even when you're "asking for" litigation, is an excuse for the court misinterpreting the contract.

I'm sure you're right that they didn't focus on valuations where IM + VM exceeded the notional during the negotiations (I can't recall that ever being a point of contention, for obvious reasons). But initial margin was frequently the main focus of those negotiations, so I don't feel bad for a protection seller that negotiated the initial margin requirement, but didn't bother to look at how their initial margin requirement interacted with their obligation to post variation margin.

Anonymous: I went to look this up. The part of the bankruptcy code in question is 546e,f,g.

Professionals have interpreted this to mean that the recipient of collateral must be party to a fraudulent conveyance in order for avoidance. (To be honest I'd have no clue how to interpret the text myself.)

Ok fair enough, it's not that obvious. The safe harbors don't create rights you don't otherwise have, they simply limit the bankruptcy code's otherwise preempting powers. Collateral foreclosure and other secured-party law is based in Articles 8 and 9 of the UCC (generally New York UCC 8 and 9 do not vary significantly from the uniform commercial code). The safe harbors do not override the UCC, so what you can do against collateral is still limited by that. Since UCC commercial law does not allow for strict foreclosure (take the collateral, give nothing back) in most applicable circumstances, you don't have the right to simply keep all the collateral you get. The safe harbors don't change that, instead they: 1) turn off the automatic stay for termination and foreclosure 2) allow netting and 3) turn off preference and fraudulent transfer provisions (absent actual knowledge of fraud) for collateral posted with the relevant clawback period for safe harbored contracts. But nothing, really nothing, in them allows you as a secured creditor to keep more than you are due, you still have to return the excess.

it may surprise you that "[a] party can breach the implied duty of good faith and fair dealing 'even if that party abides by the express and unambiguous terms of the contract if that party acts in bad faith or engages in some other form of inequitable conduct.'" Emerson Radio Corp. v. Orion Sales, Inc., 253 F.3d 159, 170 (3d Cir. 2001). if the valuation really was arbitrary, then cdo's bad faith claim has merit. but that evaluation is for another day. as you point out, this was a motion for judgment on the pleadings, not a consideration of the evidence.

Assets secures against burning. Then is a standard, an individual foreclose,buy D3 Gold of course, if there may be excess collateral, it isn't the one you have, it must resume the particular counterparty. Calling for greater than you are able to use, probably blowing out of the counterparty in a assets meltdown is definitely getting a new loan company legal responsibility just like claim get Guild Wars 2 Gold the job done contract permitted that. That is what exactly took place.

About Me

I'm a finance lawyer in New York. I used to focus on derivatives and structured finance (you know, back when there was a structured finance market). I spent the majority of my career at one of the major investment banks. My background is in economics and, unfortunately, politics.

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